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Dow Jones industrial average prepares for what could be worst month in over a year

Wall Street 81913.jpg

Gregg Maloney, center, a governor with Barclays, trades stock at the New York Stock Exchange, Monday, Aug. 19, 2013 in New York. U.S. stocks treaded water in early morning Monday trading, as investors continued to focus on the quick rise in bond yields. The Dow Jones industrial average experienced its fifth straight day of declines on Tuesday.
(Mark Lennihan / Associated Press)

At the start of the month, the Dow Jones industrial average and Standard & Poor’s 500 index hit all-time highs. Now the market is down 4 percent from its peak, and August is on track to be the Dow’s worst month since May 2012.

On Tuesday, the Dow posted in its fifth straight day of losses, the first time that’s happened this year. While the S&P 500 and Nasdaq composite index did rise modestly, it was first time in four days those indices have seen green.

The stock market slide in the last couple of weeks reflects a shift in investor strategy that began in the bond market and spilled into stocks. The spillover then mixed with lingering concerns about the U.S. economy, leading to the last several weeks of volatility, market observers say.

While most of the selloff occurred in the last couple weeks, it had its origins months ago.

Up until early June, bond funds had been one of Wall Street’s more popular investments – particularly among average investors. More than $1.2 trillion was socked away into bond mutual funds and bond exchange-traded funds between 2009 and 2012, according to TrimTabs.

“People were just throwing money at bonds, even at low rates,” says Julius Ridgway, an investment advisor with Mississippi-based firm Medley & Brown.

That was before Federal Reserve Chairman Ben Bernanke said the central bank could pull back on its $85 billion-a-month bond-purchase program, which was designed to keep bond yields low.

Bernanke made bond investors nervous in mid-June by saying that the Fed, one of the bond market’s biggest customers in the last several years, may scale back its buying. Investors pulled more than $65.8 billion out of bond funds in June, according to mutual fund research firm Lipper, the largest amount ever on a cash basis and the second largest outflow in percentage terms since the financial crisis in 2008. Investors pulled an additional $22.5 out of bond funds in July, according to Lipper.

With so many investors exiting bonds – particularly Treasuries – at the same time, bond prices declined sharply. The yield on the benchmark 10-year U.S. Treasury note has climbed from 1.63 percent in early May to as high as 2.88 percent this week. Yields climb as prices fall.

“As the 10-year yield has inched higher, the selling has led to more selling,” Krosby said.

This exodus out of bond funds has touched the stock market in two different ways, investors say, starting with dividend-paying stocks.

Shares in industries such as utilities, pharmaceuticals and telecommunications are often purchased because they provide a higher-than-normal dividend. As Treasury yields rise, it makes all dividend-paying stocks less attractive to investors. That’s because Treasuries can provide a similar return with significantly less risk.

Dividend-paying stocks have been hurt the past month. The S&P Utilities index is down nearly 5 percent while the S&P Telecommunications index is down 4 percent. Another type of investment that got hit in recent weeks was real estate investment trusts – investment companies that focus on buying and managing real estate. An index that tracks REITs, as real estate investment trusts are commonly known, is down nearly 8 percent.

Investors also have broader economic concerns. It is unclear how the possible ending of the Fed’s bond-buying program will affect growth.

“Bernanke is going to try to make this transition as smooth as possible, but we just don’t know how much (the bond buying) is going to be scaled back,” Krosby says. “And the biggest enemy to the market is uncertainty.”

Investor worries have also been heightened by bad news from retailers. Wal-Mart, Kohl’s, Macy’s and Saks all cut their investment outlooks for the year last week – raising concerns that the American consumer, who makes up roughly 70 percent of the U.S. economy, might be pulling back.

While stocks have declined noticeably in the last few weeks, it’s important to keep things in perspective, says Greg Sarian, managing director of the Sarian Group at HighTower Advisors and a certified financial planner. The S&P 500 is up 16 percent this year while the Dow is up 15 percent. In any normal year, such returns would be considered respectable for a retirement portfolio.

On Tuesday, the S&P 500 index rose 6.29 points, or 0.4 percent, to close at 1,652.35. The Nasdaq composite rose 24.50 points, or 0.7 percent, to 3,613.59. The Dow fell 7.75 points, or 0.05 percent, to 15,002.99.

Sarian says more turbulence will come until investors get clarity from the Fed about its bond-buying program.

“Expect to see more volatility or see a short-term pull back,” Sarian says.